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How to Invest in an Uncertain Stock Market

The stock market is a great place to build wealth over the long-term. Like my colleague Morgan Housel wrote in 2014:

“If you bought an index fund [in the U.S.] 20 years ago and checked your account statement for the first time this morning, you could legitimately call yourself one of the top investors of modern history, having outperformed three-quarters of professional fund managers.”

But over the short term, stock markets around the world – including the Straits Times Index (SGX: ^STI) in Singapore – have proven to be very volatile.

Just take a look at the distribution of the Straits Times Index’s annual returns in each year from the start of 1988 to the end of 2013 in the chart below. In those 26 full calendar years, Singapore’s market benchmark has enjoyed positive returns of 50% or more and has also endured yearly declines of more than 40%.

Annual return distribution for Straits Times Index (without dividends) from 1988 to 2013

Source: S&P Capital IQ

Here’s another way of looking at how volatile the stock market is over short time frames:

Maximum drawdown for Straits Times Index, 1993 - 2014

Source: S&P Capital IQ

The second chart in this article shows the worst peak-to-trough losses that the Straits Times Index has suffered in each calendar year from 1993 to 2014. And as you can see, the index had seen losses of 10% or more nearly all the time (there were only three years in which the annual peak-to-trough decline was lower than 10%).

The stock market of today may not be too different. There appears to be plenty of worries to go around. If your portfolio is a little sailboat in the ocean, the rough seas might have you feeling a little queasy. If so, there are a couple of actions you may want to consider implementing.

Diversify!

Diversification in your portfolio can come in many forms. If the aim is to reduce risk, you could consider diversifying by industry or geographical reach. The main goal here is to reduce specific risk concentrations that can affect your portfolio significantly.

Take oil and gas stocks, for instance.

The unexpected collapse in the price of oil which started last year has lead to significant declines in the share prices of many oil and gas companies. From the start of 2014 up till last Friday, shares of rig builder Keppel Corporation Limited (SGX: BN4) and oil services provider Ezion  (SGX: 5ME) were down by 26% and 45% respectively. These sizable drops may be hefty hits to any portfolio.

If the unlucky common investor had placed all his or her chips in the oil and gas sector alone, he or she has not had a happy year so far. To avoid such situations, consider diversifying into other growing sectors.

Spreading your money over time

It may also be in the common investor’s interest to consider diversifying over time.

The unlucky investor who invested all of his or her monies in the SPDR STI ETF  (SGX: ES3) –  an exchange-traded fund tracking the Straits Times Index – at its all-time high in 2007 would have had a unsatisfying experience over the past eight years; at the moment, the STI remains around 17.6% below its all-time high of more than 3,900 points that was reached in October 2007.

As pointed out earlier, the returns of the Straits Times Index from year to year may be random at best. When you put your hard earned cash into the stock market over narrow timeframes, you may be leaving your financial future to the whims of the stock market. So,  take your time to invest instead.

As a rule of thumb, try to invest no faster than half the time taken for you to save your money. If you took eight years to save $50k for instance, then take at least four years to slowly ease that amount into the market. In this way, you can diversify across time.

For what it’s worth, time-diversification is something billionaire investor Warren Buffett also advocates. Here’s what Buffett said in 2004 regarding the topic (emphasis mine):

“Among the various propositions offered to you, if you invested in a very low cost index fund – where you don’t put the money in at one time, but average in over 10 years – you’ll do better than 90% of people who start investing at the same time.”

A Fool’s take

The onus is on Foolish investors to set ourselves up for success by slowly easing into the stock market. Part of the formula in winning the investing game is about being able to hold your nerve when the rough seas inevitably hit and to continue buying great companies to hold for the long term even when the markets are falling.

By not plonking all our cash in the market at one narrow point in time in a very concentrated manner, we may help set ourselves up psychologically to take advantage of any future bargains which may appear in the market from time to time. More importantly, it also allows us to better steel ourselves in order to hold our nerve when the rough seas hit.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.